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  1. 1. Mutual Funds Chapter 14
  2. 2. Understanding Mutual Funds <ul><li>A pool of money from numerous investors used to invest in a portfolio of securities—managed by a professional portfolio manager </li></ul><ul><li>When you own shares in a mutual fund, you own a small part of the portfolio </li></ul><ul><li>Distributions of interest income, dividend income and capital gain/losses occur to investor in terms of the proportion of the total number of mutual fund shares owned </li></ul>
  3. 3. Understanding Mutual Funds <ul><li>There are over 8,000 mutual funds today </li></ul><ul><ul><li>Compared to about 600 in 1980 </li></ul></ul><ul><li>The net assets of mutual funds is about $7.5 trillion </li></ul><ul><li>Why are they so popular? </li></ul><ul><ul><li>Bull market for stocks and bonds </li></ul></ul><ul><ul><li>Growth of self-directed retirement plans </li></ul></ul>
  4. 4. Figure 14.1: Growth of Mutual Funds Source: Based on data from the Investment Company Institute.
  5. 5. How a Mutual Fund Operates <ul><li>A mutual fund raises money by selling shares of the fund to the investing public </li></ul><ul><li>The funds are used to purchase assets such as stocks, bonds, money market securities, etc. </li></ul><ul><li>The shareholder of the mutual fund is said to indirectly own the assets held by the mutual fund </li></ul><ul><li>AKA open-ended investment companies </li></ul><ul><ul><li>Constantly issues new shares and redeems existing shares </li></ul></ul>
  6. 6. How a Mutual Fund Operates <ul><li>The fund’s NET ASSET VALUE represents </li></ul><ul><ul><li>The market value of the fund’s assets, less any liabilities, divided by the number of shares outstanding </li></ul></ul>
  7. 7. How To Buy Mutual Fund Shares <ul><li>Can purchase either </li></ul><ul><ul><li>Through your stockbroker or </li></ul></ul><ul><ul><li>Directly from the mutual fund </li></ul></ul><ul><ul><ul><li>Check the fund’s Web site </li></ul></ul></ul><ul><li>Review the fund’s prospectus </li></ul><ul><ul><li>States the fund’s investment objectives, types of securities it can purchase, fees, recent performance </li></ul></ul><ul><li>Send in your application along with a check </li></ul>
  8. 8. Services Offered <ul><li>Automatic reinvestment of distributions </li></ul><ul><ul><li>Effectively increases the number of shares you own </li></ul></ul><ul><li>Automatic investment plans </li></ul><ul><ul><li>Can be as little as $50 a month </li></ul></ul><ul><li>Exchange privileges </li></ul><ul><ul><li>Transfer within fund family </li></ul></ul><ul><li>Check writing </li></ul><ul><ul><li>Mostly money market funds (and a few others) allow minimum checks ($500+ each) </li></ul></ul><ul><ul><li>Doesn’t replace a regular checking account </li></ul></ul>
  9. 9. Regulation and Taxation <ul><li>Regulated by SEC </li></ul><ul><ul><li>Must present certain types of information in prospectus and other reports </li></ul></ul><ul><ul><li>Limits types of advertising </li></ul></ul><ul><li>If mutual fund retains investment profit, it must pay taxes on it; therefore, most mutual funds distribute the gains to shareholders </li></ul><ul><ul><li>Shareholders must report these distributions for tax purposes, as well as any gain/loss on redemption of shares </li></ul></ul>
  10. 10. Where to Get Mutual Fund Information <ul><li>Internet </li></ul><ul><li>Money’s February issue is heavily devoted to mutual funds </li></ul><ul><li>The Wall Street Journal publishes a mutual fund section regularly </li></ul>
  11. 11. Classifying Mutual Funds <ul><li>Can be classified based on </li></ul><ul><ul><li>Investment objectives </li></ul></ul><ul><ul><li>Investment style </li></ul></ul><ul><ul><li>Types of securities owned by fund </li></ul></ul><ul><ul><ul><li>Stocks </li></ul></ul></ul><ul><ul><ul><li>Bonds (or income) </li></ul></ul></ul><ul><ul><ul><li>Hybrid (balanced) </li></ul></ul></ul><ul><ul><ul><li>Money market </li></ul></ul></ul>
  12. 12. Figure 14.2: Distribution of Mutual Fund Assets Source: Based on data from the Investment Company Institute.
  13. 13. Classifying Mutual Funds <ul><li>Common subcategories for stock funds </li></ul><ul><ul><li>Aggressive growth </li></ul></ul><ul><ul><li>Growth and income </li></ul></ul><ul><ul><li>Long-term growth </li></ul></ul><ul><ul><li>Small-company growth </li></ul></ul><ul><ul><li>International </li></ul></ul><ul><li>Common subcategories for bond funds </li></ul><ul><ul><li>Government </li></ul></ul><ul><ul><li>High-yield corporate (junk bonds) </li></ul></ul><ul><ul><li>Investment-grade corporate </li></ul></ul><ul><ul><li>World income </li></ul></ul><ul><ul><li>Mortgage-backed securities </li></ul></ul><ul><ul><li>Municipal bond </li></ul></ul>
  14. 14. Classifying Mutual Funds <ul><li>Common subcategories for money market funds </li></ul><ul><ul><li>Government </li></ul></ul><ul><ul><li>Taxable </li></ul></ul><ul><ul><li>Tax-exempt </li></ul></ul>
  15. 15. Mutual Fund ‘Styles’ <ul><li>Even mutual funds that fall into the same subcategory can have different management styles </li></ul><ul><ul><li>One fund may try to achieve growth by investing in stocks with potential for strong earnings growth; whereas </li></ul></ul><ul><ul><li>Another fund may try to achieve same objective by selecting stocks it currently believes to be currently undervalued in the market </li></ul></ul>
  16. 16. Different Fund Types <ul><li>Some fairly new fund types </li></ul><ul><ul><li>Asset allocation funds </li></ul></ul><ul><ul><ul><li>Invest in a mixture of stocks, bonds, and money market instruments, shifting allocation of money in an attempt to gain high returns with low risk </li></ul></ul></ul><ul><ul><li>Index funds </li></ul></ul><ul><ul><ul><li>Attempt to replicate performance of a major stock index (most popular is S&P 500) </li></ul></ul></ul><ul><ul><ul><li>Why are these so appealing? </li></ul></ul></ul><ul><ul><ul><ul><li>Very low fees (not that much management to be done) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Most mutual fund managers can’t consistently outperform the market </li></ul></ul></ul></ul><ul><ul><li>Sector funds </li></ul></ul><ul><ul><ul><li>Invest only in one industry </li></ul></ul></ul>
  17. 17. Advantages of Mutual Funds <ul><li>Diversification </li></ul><ul><ul><li>Can increase your return without increasing your risk (or may even reduce your risk) </li></ul></ul><ul><ul><ul><li>But doesn’t eliminate risk! </li></ul></ul></ul><ul><ul><li>Not all mutual funds are diversified—they’re not meant to be </li></ul></ul>
  18. 18. Advantages of Mutual Funds <ul><li>Smaller minimum investments </li></ul><ul><ul><li>Can purchase a piece of a well-diversified portfolio for a relatively small investment </li></ul></ul><ul><ul><li>Money market mutual funds minimum investment  $1,000 </li></ul></ul><ul><ul><li>Stock and bond mutual funds minimum investment  $1,000–$3,000 (less for IRAs) </li></ul></ul><ul><ul><ul><li>Additional investments can be as little as $50–$100 </li></ul></ul></ul><ul><ul><ul><li>Many funds offer automatic investment plans that require initial investments of as little as $50 </li></ul></ul></ul>
  19. 19. Advantages of Mutual Funds <ul><li>Professional management </li></ul><ul><ul><li>Do all mutual funds always beat the market? </li></ul></ul><ul><ul><ul><li>Over the past 10 years, stock funds have had an average annual return about 1.5% less than the S&P 500 (9% vs. 10.5%) </li></ul></ul></ul>
  20. 20. Picking the Right Mutual Funds <ul><li>Step 1: Choose your investment goals and assess your risk/return position </li></ul><ul><ul><li>You can then identify the types (group) of mutual funds that meet your criteria </li></ul></ul><ul><li>Step 2: Assess the fees and performance of the mutual funds </li></ul>
  21. 21. Fees and Expenses <ul><li>Several types of fees </li></ul><ul><ul><li>Load charges: fees associated with either buying or redeeming mutual fund shares </li></ul></ul><ul><ul><ul><li>Front-end – paid when shares are purchased </li></ul></ul></ul><ul><ul><ul><ul><li>Cannot exceed 8.5% </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Example: You deposit $1000 in a fund with a 2% front-end load—only $980 goes toward purchase of shares, the remaining $20 is a fee </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Most funds use front-end loads with very few actually charging the maximum 8.5% </li></ul></ul></ul></ul><ul><ul><ul><li>Redemption fee (back-end load) – paid when shares are sold </li></ul></ul></ul><ul><ul><ul><ul><li>Often depends on how long the shares were owned—with a lower fee charged for a longer holding period </li></ul></ul></ul></ul>
  22. 22. Fees and Expenses <ul><li>Trend is toward low front-end loads or no-loads </li></ul><ul><ul><li>No charges associated with buying or selling the mutual fund </li></ul></ul><ul><li>Over half of all mutual funds are no-load </li></ul><ul><li>Annual operating expenses </li></ul><ul><ul><li>Includes fees paid to portfolio manager, transaction costs, printing costs </li></ul></ul><ul><ul><li>Paid from investment income before it is distributed </li></ul></ul><ul><ul><ul><li>Average is about 1.5% for stock funds; 1.1% for bond funds </li></ul></ul></ul><ul><ul><li>12b-1 fees </li></ul></ul><ul><ul><ul><li>Pays for distribution costs (such as advertising) in lieu of a load charge </li></ul></ul></ul>
  23. 23. Fees and Expenses <ul><li>Evaluating fees and expenses </li></ul><ul><ul><li>Not all funds charge the same operating fee % — shop around </li></ul></ul><ul><ul><li>Can range from 0.1% to 2.5+% </li></ul></ul><ul><ul><li>Fees and expenses can have a dramatic impact on the value of your investment over time </li></ul></ul><ul><ul><li>No definitive evidence shows that funds charging higher fees earn higher returns </li></ul></ul><ul><ul><ul><li>Everything else being equal, you’re better off buying a no-load fund with low operating costs </li></ul></ul></ul>
  24. 24. Performance <ul><li>Need to examine absolute performance AND relative performance as well as risk </li></ul><ul><li>When comparing fund to a benchmark, choose the right benchmark </li></ul>
  25. 25. The Relationship Between Past and Future Performance <ul><li>Some funds beat the market some years and not others </li></ul><ul><ul><li>Should we try to predict which funds will beat the averages next year (or during the next 5 years) or not? </li></ul></ul><ul><ul><ul><li>Randomly choosing funds will probably lead to the same results according to some people </li></ul></ul></ul><ul><ul><li>Others argue that superior funds may underperform some years, but over the long run produce superior returns </li></ul></ul>
  26. 26. The Relationship Between Past and Future Performance <ul><li>Results are mixed </li></ul><ul><li>Conclusion </li></ul><ul><ul><li>Don’t chase returns—the fees are too great and your results probably won’t be stellar </li></ul></ul><ul><ul><li>Past performance in NO WAY GUARANTEES FUTURE PERFORMANCE </li></ul></ul>
  27. 27. Performance and Taxes <ul><li>Mutual funds pass investment income and realized capital gains to shareholders, so taxes must be paid on these distributions </li></ul><ul><li>The more distributions paid to you, the more taxes you’ll pay </li></ul>
  28. 28. When Not to Buy Mutual Fund Shares <ul><li>Most mutual funds have regularly scheduled distribution dates </li></ul><ul><li>For tax purposes, you shouldn’t buy shares in a mutual fund right before a distribution </li></ul><ul><ul><li>You’d owe taxes on that immediate distribution </li></ul></ul>
  29. 29. What About Index Funds <ul><li>Designed to track performance of a broad stock or bond market index </li></ul><ul><ul><li>Most popular track the S&P500 </li></ul></ul><ul><li>Number of index funds has grown rapidly </li></ul>
  30. 30. Making Changes to Your Mutual Fund Investments <ul><li>Will your goals remain the same for the next 30–40 years? </li></ul><ul><ul><li>No—the mix of your investments will need to change over time </li></ul></ul><ul><li>You’ll also need to rebalance over time </li></ul><ul><ul><li>Adjusting investments periodically to return to the target asset allocation </li></ul></ul>
  31. 31. When to Sell a Mutual Fund <ul><li>One reason many people sell shares is due to poor performance </li></ul><ul><ul><li>BUT, selling shares based on poor short-term performance may be a bad idea </li></ul></ul><ul><ul><ul><li>Are you chasing past returns? </li></ul></ul></ul><ul><ul><ul><ul><li>This rarely produces superior returns over the long run </li></ul></ul></ul></ul><ul><ul><ul><li>Even the best funds have poor performance at times </li></ul></ul></ul><ul><ul><li>If you have a good fund, keep it even if it offers poor short-term performance </li></ul></ul>
  32. 32. When to Sell a Mutual Fund <ul><li>There are viable reasons for selling a fund </li></ul><ul><ul><li>Performance lags behind the benchmarks for an extended time period (three years or so) </li></ul></ul><ul><ul><li>Fund gets very large very fast </li></ul></ul><ul><ul><li>Expenses keep rising </li></ul></ul><ul><ul><ul><li>Fund is trying to capitalize on its popularity </li></ul></ul></ul><ul><ul><li>Management turnover </li></ul></ul>